Strong reactions to a weak yen shake Japan’s economy

The Japanese real effective exchange rate is now at its lowest level in 54 years. Despite the pressures of a depreciating yen — from import prices to debt repayment — Japan’s global competitiveness and financial markets make it well-equipped to handle these challenges.

The Bank of Japan (BOJ) has tightened monetary policy cautiously. It abandoned negative rates on the uncollateralised overnight call rate in March 2024 and raised the target to 0.25 per cent in July 2024 and to 0.5 per cent in January 2025. The move in July sparked a 6 per cent appreciation of the yen and a 12 per cent drop in the stock market, while the move in January proved uneventful.

BOJ Governor Kazuo Ueda has been waiting for what he calls good inflation — inflation driven by wage increases that increase consumption and aggregate demand — to tighten policy. Despite years of easy monetary policy and wages increasing 5.1 per cent in the 2024 spring wage offensive, real disposable income has not increased. This has led to sluggish growth in real consumption.

The BOJ may face pressure to tighten in order to resist a disorderly depreciation of the yen. This is especially true as the US Federal Reserve may slow monetary policy easing because of inflationary risks due to tariffs, large US budget deficits and the repatriation of illegal immigrants.

The weak yen increases the prices of imported energy and food. This has raised average household costs in 2024 by 90,000 yen (US$590). To combat this, Japanese Prime Minister Shigeru Ishiba implemented stimulus measures to subsidise utility bills and provide cash for poorer households.

But one problem with both the BOJ’s tightening and Ishiba’s stimulus package is that they increase budget deficits. By raising interest rates, the BOJ raises the cost of servicing Japan’s public debt. At 1.2 per cent, yields on 10-year Japanese government bonds are at their highest level in 14 years. Debt service costs in 2025 are already forecasted to be above 4 per cent of GDP.

Ishiba’s package, along with increased spending on military and social security categories, will turn the forecasted primary budget — the budget excluding interest payments — from a surplus into a deficit of 0.7 per cent of GDP in 2025. With a public debt of 250 per cent of GDP, Japan needs to eschew additional borrowing. It should instead allow entrepreneurs to play a larger role in allocating resources.

The weak yen also impacts Japan’s international transactions. It raises the costs of imports of food, fuels and other items. Yet the stimulus to exports is mitigated as many manufacturers relocated factories abroad during the strong yen period that lasted until 2012.

Since the weak yen increases the cost of imports and has a tenuous impact on exports, it contributed to a trade deficit in 2024. But the weak yen raised the yen value of repatriated profits and contributed to a 47 per cent increase in tourism. Primary income inflows and tourism revenues more than offset the trade deficit, pushing the overall Japanese current account to a surplus of 4 per cent of GDP.

The Nikkei 225 stock market index also benefitted from the weak yen. It increased 19 per cent in 2024 and finished at its highest year-end level ever. Much of this occurred because the weak yen increased the yen profitability of companies such as Toyota and Komatsu, who obtain revenues from abroad.

It has yet to be seen whether many Japanese firms who moved factories abroad during strong yen episodes —such as after the 1985 Plaza Accord and the 2008–09 Global Financial Crisis — will return production to Japan as the yen remains weak. The government has pushed to return semiconductor manufacturing to Japan. The weak yen may help this plan succeed.

As an oil importer, Japan faces challenges from high energy costs which are only raised with yen depreciation. It is seeking to reduce its dependence on fossil fuels, and to promote renewables and safe nuclear power. Somewhat paradoxically for an oil importer, oil price increases raise stock prices for Japanese industrial firms. This is because Japanese companies produce niche goods and services that are needed as energy prices increase.

These high-quality niche products also improve the resilience of the Japanese economy. Japanese firms produce the lion’s share of photoresists and image sensors, used in the electronics industry and medical equipment. Japanese firms are also major suppliers of inputs to the semiconductor industry.

With Japan consistently ranking as the most sophisticated economy, finding substitutes for many Japanese goods is hard. This provides Japanese companies with a stable source of demand for their products across Southeast Asia, Taiwan, South Korea, China, Europe and the United States. This diversification reduces their exposure to difficulties in individual markets such as China.

Japan will face challenges in 2025, including uncertainties from United States President Donald Trump, competition from South Korean and Chinese firms, dangers from wars and natural disasters, a shrinking workforce and an aging population. Japanese companies have navigated difficulties associated with the Russia–Ukraine war, the COVID-19 pandemic and the weak yen. These past successes provide reason for optimism that Japan can weather the coming shocks.

Willem Thorbecke is Senior Fellow at the Research Institute of Economy, Trade and Industry, Japan.